ACCOUNTING

What You Need to Know About Stock

Options
by Brian J. Hall
FROM THE MARCHAPRIL 2000 ISSUE

T wenty years ago, the biggest component of executive compensation was cash, in the form of salaries and bonuses. Stock
options were just a footnote. Now the reverse is true. With astounding speed, stock option grants have come to dominate
the payand often the wealthof top executives throughout the United States. Last year, Jack Welchs unexercised GE
options were valued at more than $260 million. Intel CEO Craig Barretts were worth more than $100 million. Michael Eisner
exercised 22 million options on Disney stock in 1998 alone, netting more than a half-billion dollars. In total, U.S. executives hold
unexercised options worth tens of billions of dollars.

It would be dicult to exaggerate how much the options explosion has changed corporate America. But has the change been for the
better or for the worse? Certainly, option grants have improved the fortunes of many individual executives, entrepreneurs, software
engineers, and investors. Their long-term impact on business in general remains much less clear, however. Even some of the people
who have proted most from the trend express a deep discomfort about their companies growing dependence on options. Do we
really know what were doing? they ask. Are the incentives were creating in line with our business goals? Whats going to happen
when the bull market ends?

Option grants are even more controversial for many outside observers. The grants seem to shower ever greater riches on top
executives, with little connection to corporate performance. They appear to oer great upside rewards with little downside risk.
And, according to some very vocal critics, they motivate corporate leaders to pursue short-term moves that provide immediate
boosts to stock values rather than build companies that will thrive over the long run. As the use of stock options has begun to
expand internationally, such concerns have spread from the United States to the business centers of Europe and Asia.

I have been studying the use of option grants for a number of years now, modeling how their values change under dierent
circumstances, evaluating how they interact with other forms of compensation, and examining how the various programs support
or undermine companies business goals. What Ive found is that the critics of options are mistaken. Options do not promote a
selsh, near-term perspective on the part of businesspeople. Quite the contrary. Options are the best compensation mechanism we
have for getting managers to act in ways that ensure the long-term success of their companies and the well-being of their workers
and stockholders.

But Ive also found that the general nervousness about options is well warranted. Stock options are baingly complex nancial
instruments. (See the sidebar A Short Course on Options and Their Valuation.) They tend to be poorly understood by both those
who grant them and those who receive them. As a result, companies often end up having option programs that are
counterproductive. I have, for example, seen many Silicon Valley companies continue to use their pre-IPO programswith
unfortunate consequencesafter the companies have grown and gone public. And Ive seen many large, sleepy companies use
option programs that unwittingly create weak incentives for innovation and value creation. The lesson is clear: its not enough just
to have an option program; you need to have the right program.
 Before discussing the strengths and weaknesses of dierent types
A Short Course on Options and Their
Valuation of programs, Id like to step back and examine why option grants

Executive stock options are call options. They give the are, in general, an extraordinarily powerful form of
holder the right, but not the obligation, to purchase a compensation.
companys shares at a specied pricethe exercise or
strike price. In the vast majority of cases, options are
granted at the money, which means that the exercise The Pay-to-Performance Link
price matches the stock price at the time of the grant. A
The main goal in granting stock options is, of course, to tie pay to
small minority of options are granted out of the money,
with an exercise price higher than the stock pricethese performanceto ensure that executives prot when their
are premium options. An even smaller minority are companies prosper and suer when they ounder. Many critics
granted in the money, with an exercise price lower than claim that, in practice, option grants have not fullled that goal.
the stock pricethese are discount options.
Executives, they argue, continue to be rewarded as handsomely
The options issued to executives usually have important
for failure as for success. As evidence, they either use anecdotes
restrictions. They cant be sold to a third party, and they
must be exercised before a dened maturity date, which examples of poorly performing companies that compensate their
is typically ten years from the grant date. Most, but not top managers extravagantlyor they cite studies indicating that
all, have a vesting period, usually of between three and
the total pay of executives in charge of high-performing
ve years; the option holder does not actually own the
option, and therefore may not exercise it, until the option companies is not much dierent from the pay of those heading
vests. Option holders do not usually receive dividends, poor performers. The anecdotes are hard to disputesome
which means they make a prot only on any appreciation companies do act foolishly in paying their executivesbut they
of the stock price beyond the exercise price.
dont prove much. The studies are another matter. Virtually all of
The value of an option is typically measured with the
them share a fatal aw: they measure only the compensation
Black-Scholes pricing model or some variation. Black-
Scholes provides a good estimate of the price an earned in a given year. Whats left out is the most important
executive could receive for an option if he could sell it. component of the pay-to-performance linkthe appreciation or
Since such an option cannot be sold, its actual value to an
depreciation of an executives holdings of stock and options.
executive is typically less than its Black-Scholes value.1
Nevertheless, understanding Black-Scholes valuations is
helpful because they provide a useful benchmark.
Black-Scholes takes account of the many factors that
affect the value of an optionnot only the stock price,
but also the exercise price, the maturity date, the
prevailing interest rates, the volatility of the companys
stock, and the companys dividend rate. The last two
factorsvolatility and dividend rateare particularly
important because they vary greatly from company to
company and have a large inuence on option value. Lets
look at each of them:
Volatility. The higher the volatility of a companys stock
price, the higher the value of its options. The logic here is
that while the owner of an option will receive the full
value of any upside change, the downside is limitedan
options payoff hits zero once the stock price falls to the
exercise price, but if the stock falls further, the options
payoff remains at zero. (Thats not to say that options
have no down-side. They lose their value quickly and can
end up worth nothing.) The higher expected payoff raises
the options value. But the potential for higher payoff is
not without a costhigher volatility makes the payoff
riskier to the executive.
Dividend Rate. The higher a companys dividend rate, the
lower the value of its options. Companies reward their
shareholders in two ways: by increasing the price of their
stock and by paying dividends. Most option holders,
however, do not receive dividends; they are rewarded
only through price appreciation. Since a company that
pays high dividends has less cash for buying back shares
or protably reinvesting in its business, it will have less
share-price appreciation, all other things being equal.
Therefore, it provides a lower return to option holders.
Research by Christine Jolls of Harvard Law School
As executives at a company receive yearly option grants, they
begin to amass large amounts of stock and unexercised options.
The value of those holdings appreciates greatly when the
companys stock price rises and depreciates just as greatly when it
falls. When the shifts in value of the overall holdings are taken
into account, the link between pay and performance becomes
much clearer. Indeed, in a study I conducted with Jerey
Liebman of Harvards Kennedy School of Government, we found
that changes in stock and stock option valuations account for 98%
of the link between pay and performance for the average chief
executive, while annual salary and bonus payments account for a
mere 2%.
By increasing the number of shares executives control, option
grants have dramatically strengthened the link between pay and
performance. Take a look at the exhibit Tying Pay to
Performance. It shows how two measures of the pay-to-
performance link have changed since 1980. One measure is the
amount by which an average CEOs wealth changes when his
companys market value changes by $1,000. The other measure
shows the amount by which CEO wealth changes with a 10%
change in company value. For both measures, the link between
pay and performance has increased nearly tenfold since 1980.
While there are many reasons American companies have
ourished over the last two decades, its no coincidence that the
suggests, in fact, that the options explosion is partially boom has come in the wake of the shift in executive pay from
responsible for the decline in dividend rates and the
cash to equity. In stark contrast to the situation 20 years ago,
increase in stock repurchases during the past decade.
when most executives tended to be paid like bureaucrats and act
The chart The Effect of Volatility and Dividend Rate on
like bureaucrats, todays executives are much more likely to be
Option Value shows how changes in volatility and
dividend rate affect the value of an at-the-money option paid like owners and act like owners.
with a ten-year maturity. For a company with 30%
volatilityabout the average for the Fortune 500and a
2% dividend rate, an option is worth about 40% of the
price of a share of stock. Increase the volatility to 70%,
and the options value goes up to 64% of the stock price.
Decrease the dividend rate to 0, and the options value
goes up to 56%. Do both, and the options value shoots
up to 81%.
Its important to note that Black-Scholes is just a formula;
its not a method for picking stocks. It cant, and makes
no attempt to, make predictions about which companies
will perform well and which will perform poorly. In the
end, the factor that will determine an options payoff is
the change in the price of the underlying stock. If you are
an executive, you can raise the value of your options by
taking actions that increase the value of the stock. Thats
the whole idea of option grants.
The Effect of Volatility and Dividend Rate on Option Value
Option value is stated as a fraction of stock price.
Volatility is stated as the annual standard deviation of the
companys stock-price returns. The gures assume a ten-
year at-the-money option with a prevailing risk-free rate
(ten-year bond rate) of 6%. For Fortune 500 companies,
30% volatility is about the average.
1. For a framework on how to measure the value of
nontradable executive (and employee) stock options, see
Brian J. Hall and Kevin J. Murphy, Optimal Exercise
Prices for Executive Stock Options, American Economic
Review (May 2000).
Tying Pay to Performance

Given the complexity of options, though, it is reasonable to ask a simple question: if the goal is to align the incentives of owners and
managers, why not just hand out shares of stock? The answer is that options provide far greater leverage. For a company with an
average dividend yield and a stock price that exhibits average volatility, a single stock option is worth only about one-third of the
value of a share. Thats because the option holder receives only the incremental appreciation above the exercise price, while the
stockholder receives all the value, plus dividends. The company can therefore give an executive three times as many options as
shares for the same cost. The larger grant dramatically increases the impact of stock price variations on the executives wealth. (In
addition to providing leverage, options oer accounting advantages. See the sidebar Accounting for Options.)

The idea of using leveraged incentives is not new. Most

Accounting for Options salespeople, for example, are paid a higher commission rate on

Under current accounting rules, as long as the number the revenues they generate above a certain target. For instance,
and exercise price of options are xed in advance, their they might receive 2% of sales up to $1 million and 10% of sales
cost never hits the P&L. That is, options are not treated as
an expense, either when theyre granted or when theyre above $1 million. Such plans are more dicult to administer than
exercised. The accounting treatment of options has
plans with a single commission rate, but when it comes to
generated enormous controversy. On one side are some
shareholders who argue that because options are compensation, the advantages of leverage often outweigh the
compensation and compensation is an expense, options disadvantages of complexity.
should show up on the P&L. On the other side are many
executives, especially those in small companies, who
counter that options are difcult to value properly and The Downside Risk
that expensing them would discourage their use.
If pay is truly to be linked to performance, its not enough to
The response of institutional investors to the special deliver rewards when results are good. You also have to impose
treatment of options has been relatively muted. They
penalties for weak performance. The critics claim options have
have not been as critical as one might expect. There are
two reasons for this. First, companies are required to list unlimited upside but no downside. The implicit assumption is
their option expenses in a footnote to the balance sheet, that options have no value when granted and that the recipient
so savvy investors can easily gure option costs into
thus has nothing to lose. But that assumption is completely false.
expenses. Even more important, activist shareholders
have been among the most vocal in pushing companies to Options do have value. Just look at the nancial exchanges,
replace cash pay with options. They dont want to do where options on stock are bought and sold for large sums of
anything that might turn companies back in the other money every second. Yes, the value of option grants is illiquid
direction.
and, yes, the eventual payo is contingent on the future
In my view, the worst thing about the current accounting
performance of the company. But they have value nonetheless.
rules is not that they allow companies to avoid listing
options as an expense. Its that they treat different types And if something has value that can be lost, it has, by denition,
of option plans differently, for no good reason. That downside risk.
discourages companies from experimenting with new
kinds of plans. As just one example, the accounting rules
penalize discounted, indexed optionsoptions with an In fact, options have even greater downside risk than stock.
exercise price that is initially set beneath the current Consider two executives in the same company. One is granted a
stock price and that varies according to a general or
million dollars worth of stock, and the other is granted a million
industry-specic stock-market index. Although indexed
options are attractive because they isolate company dollars worth of at-the-money optionsoptions whose exercise
price matches the stock price at the time of the grant. If the stock
 performance from broad stock-market trends, they are
almost nonexistent, in large part because the accounting
rules dissuade companies from even considering them.
For more on indexed options, see Alfred Rappaports
New Thinking on How to Link Executive Pay with
Performance (HBR, MarchApril 1999).
price falls sharply, say by 75%, the executive with stock has lost
$750,000, but she retains $250,000. The executive with options,
however, has essentially been wiped out. His options are now so
far under water that they are nearly worthless. Far from
eliminating penalties, options actually amplify them.

The downside risk has become increasingly evident to executives

as their pay packages have come to be dominated by options.
Take a look at the employment contract Joseph Galli negotiated with Amazon.com when he recently agreed to become the e-tailers
COO. In addition to a large option grant, his contract contains a protection clause that requires Amazon to pay him up to $20 million
if his options dont pay o. One could argue that providing such protection to executives is foolish from a shareholders point of
view, but the contract itself makes an important point: why would someone need such protection if options had no downside risk?

The risk inherent in options can be undermined, however, through the practice of repricing. When a stock price falls sharply, the
issuing company can be tempted to reduce the exercise price of previously granted options in order to increase their value for the
executives who hold them. Such repricing is anathema to shareholders, who dont enjoy the privilege of having their shares
repriced. Although fairly common in small companiesespecially those in Silicon Valleyoption repricing is relatively rare for
senior managers of large companies, despite some well-publicized exceptions. In 1998, fewer than 2% of all large companies
repriced any options for their top executive teams. Even for companies that had large decreases in their stock pricesdeclines of
25% or worse in the previous yearthe repricing rate was less than 5%. And only 8% of companies with market-value declines of
more than 50% repriced. In most cases, companies that resorted to repricing could have avoided the need to do so by using a
dierent kind of option program, as Ill discuss later.

Promoting the Long View

Its often assumed that when you tie compensation to stock price, you encourage executives to take a short-term focus. They end up
spending so much time trying to make sure that the next quarters results meet or beat Wall Streets expectations that they lose sight
of whats in the best long-term interests of their companies. Again, however, the criticism does not stand up to close examination.

For a method of compensation to motivate managers to focus on the long term, it needs to be tied to a performance measure that
looks forward rather than backward. The traditional measureaccounting protsfails that test. It measures the past, not the
future. Stock price, however, is a forward-looking measure. It forecasts how current actions will aect a companys future prots.
Forecasts can never be completely accurate, of course. But because investors have their own money on the line, they face enormous
pressure to read the future correctly. That makes the stock market the best predictor of performance we have.

But what about the executive who has a great long-term strategy that is not yet fully appreciated by the market? Or, even worse,
what about the executive who can fool the market by pumping up earnings in the short run while hiding fundamental problems?
Investors may be the best forecasters we have, but they are not omniscient. Option grants provide an eective means for addressing
these risks: slow vesting. In most cases, executives can only exercise their options in stages over an extended periodfor example,
25% per year over four years. That delay serves to reward managers who take actions with longer-term payos while exacting a
harsh penalty on those who fail to address basic business problems.

Stock options are, in short, the ultimate forward-looking incentive planthey measure future cash ows, and, through the use of
vesting, they measure them in the future as well as in the present. They dont create managerial myopia; they help to cure it. If a
company wants to encourage a more farsighted perspective, it should not abandon option grantsit should simply extend their
vesting periods.1

Three Types of Plans

Most of the companies Ive studied dont pay a whole lot of attention to the way they grant options. Their directors and executives
assume that the important thing is just to have a plan in place; the details are trivial. As a result, they let their HR departments or
compensation consultants decide on the form of the plan, and they rarely examine the available alternatives. Often, they arent
even aware that alternatives exist.

But such a laissez-faire approach, as Ive seen over and over again, can lead to disaster. The way options are granted has an
enormous impact on a companys eorts to achieve its business goals. While option plans can take many forms, I nd it useful to
divide them into three types. The rst twowhat I call xed value plans and xed number plansextend over several years. The
thirdmegagrantsconsists of onetime lump sum distributions. The three types of plans provide very dierent incentives and
entail very dierent risks.

Fixed Value Plans.

With xed value plans, executives receive options of a predetermined value every year over the life of the plan. A companys board
may, for example, stipulate that the CEO will receive a $1 million grant annually for the next three years. Or it may tie the value to
some percentage of the executives cash compensation, enabling the grant to grow as the executives salary or salary plus bonus
increases. The value of the options is typically determined using Black-Scholes or similar valuation formulas, which take into
account such factors as the number of years until the option expires, prevailing interest rates, the volatility of the stock price, and
the stocks dividend rate.

Fixed value plans are popular today. Thats not because theyre intrinsically better than other planstheyre notbut because they
enable companies to carefully control the compensation of executives and the percentage of that compensation derived from option
grants. Fixed value plans are therefore ideal for the many companies that set executive pay according to studies performed by
compensation consultants that document how much comparable executives are paid and in what form.2 By adjusting an executives
pay package every year to keep it in line with other executives pay, companies hope to minimize what the consultants call
retention riskthe possibility that executives will jump ship for new posts that oer more attractive rewards.
But xed value plans have a big drawback. Because they set the value of future grants in advance, they weaken the link between pay
and performance. Executives end up receiving fewer options in years of strong performance (and high stock values) and more
options in years of weak performance (and low stock values). To see how that works, lets look at the pay of a hypothetical CEO
whom Ill call John. As part of his pay plan, John receives $1 million in at-the-money options each year. In the rst year, the
companys stock price is $100, and John receives about 28,000 options. Over the next year, John succeeds in boosting the
companys stock price to $150. As a result, his next $1 million grant includes only 18,752 options. The next year, the stock price
goes up another $50. Johns grant falls again, to 14,000 options. The stock price has doubled; the number of options John receives
has been cut in half. (The exhibit The Impact of Dierent Option Plans on Compensation summarizes the eect of stock price
changes on the three kinds of plans.)

The Impact of Dierent Option Plans on Compensation Option values are derived using the Black-Scholes model and reect the
characteristics of a typical but hypothetical Fortune 500 company; the annual standard deviation of the stock price is assumed to be
32%, the risk-free rate of return is 6%, the dividend rate is 3%, and the maturity period is ten years.
Now lets look at what happens to Johns grants when his company performs miserably. In the rst year, the stock price falls from
$100 to $65. Johns $1 million grant provides him with 43,000 options, up considerably from the original 28,000. The stock price
continues to plummet the next year, falling to just $30. Johns grant jumps to nearly 94,000 options. He ends up, in other words,
being given a much larger piece of the company that he appears to be leading toward ruin.

Its true that the value of Johns existing holdings of options and shares will vary considerably with changes in stock price. But the
annual grants themselves are insulated from the companys performancein much the same way that salaries are. For that reason,
xed value plans provide the weakest incentives of the three types of programs. I call them low-octane plans.

Fixed Number Plans.

Whereas xed value plans stipulate an annual value for the options granted, xed number plans stipulate the number of options the
executive will receive over the plan period. Under a xed number plan, John would receive 28,000 at-the-money options in each of
the three years, regardless of what happened to the stock price. Here, obviously, there is a much stronger link between pay and
performance. Since the value of at-the-money options changes with the stock price, an increase in the stock price today increases
the value of future option grants. Likewise, a decrease in stock price reduces the value of future option grants. For John, boosting
the stock price 100% over two years would increase the value of his annual grant from $1 million in the rst year to $2 million in the
third. A 70% drop in the stock price, by contrast, would reduce the value of his grant to just $300,000.

Since xed number plans do not insulate future pay from stock price changes, they create more powerful incentives than xed value
plans. I call them medium-octane plans, and, in most circumstances, I recommend them over their xed value counterparts.

Megagrant Plans.
Now for the high-octane model: the lump-sum megagrant. While not as common as the multiyear plans, megagrants are widely
used among private companies and post-IPO high-tech companies, particularly in Silicon Valley. Megagrants are the most highly
leveraged type of grant because they not only x the number of options in advance, they also x the exercise price. To continue
with our example, John would receive, at the start of the rst year, a single megagrant of nearly 80,000 options, which has a Black-
Scholes value of $2.8 million (equivalent to the net present value of $1 million per year for three years). Shifts in stock price have a
dramatic eect on this large holding. If the stock price doubles, the value of Johns options jumps to $8.1 million. If the price drops
70%, his options are worth a mere $211,000, less than 8% of the original stake.

Disneys Michael Eisner is perhaps the best known CEO who has received megagrants. Every few years since 1984, Eisner has
received a megagrant of several million shares. It is the leverage of these packages, coupled with the large gains in Disneys stock
during the last 15 years, that has made Eisner so fabulously wealthy.

The Big Trade-Off

Since the idea behind options is to gain leverage and since megagrants oer the most leverage, you might conclude that all
companies should abandon multi-year plans and just give high-octane megagrants. Unfortunately, its not so simple. The choice
among plans involves a complicated trade-o between providing strong incentives today and ensuring that strong incentives will
still exist tomorrow, particularly if the companys stock price falls substantially.

When viewed in those terms, megagrants have a big problem. Look at what happened to John in our third scenario. After two years,
his megagrant was so far under water that he had little hope of making much money on it, and it thus provided little incentive for
boosting the stock value. And he was not receiving any new at-the-money options to make up for the worthless onesas he would
have if he were in a multiyear plan. If the drop in stock value was a result of poor management, Johns pain would be richly
deserved. If, however, the drop was related to overall market volatilityor if the stock had been overvalued when John took charge
then Johns suering would be dangerous for the company. It would provide him with a strong motivation to quit, join a new
company, and get some new at-the-money options.
Ironically, the companies that most often use megagrantshigh-tech start-upsare precisely those most likely to endure such a
worst-case scenario. Their stock prices are highly volatile, so extreme shifts in the value of their options are commonplace. And
since their people are in high demand, they are very likely to head for greener pastures when their megagrants go bust. Indeed,
Silicon Valley is full of megagrant companies that have experienced human resources crises in response to stock price declines. Such
companies must choose between two bad alternatives: they can reprice their options, which undermines the integrity of all future
option plans and upsets shareholders, or they can refrain from repricing and watch their demoralized employees head out the door.

Adobe Systems, Apple Computer, E*Trade, Netscape, PeopleSoft, and Sybase have all repriced their options in recent years, despite
the bad will it creates among shareholders. As one Silicon Valley executive told me, You have to reprice. If you dont, employees
will walk across the street and reprice themselves.

Silicon Valley companies could avoid many such situations by using multiyear plans. So why dont they? The answer lies in their
heritage. Before going public, start-ups nd the use of megagrants highly attractive. Accounting and tax rules allow them to issue
options at signicantly discounted exercise prices. These penny options have little chance of falling under water (especially in the
absence of the stock price volatility created by public markets). The risk prole of these pre-IPO grants is actually closer to that of
shares of stock than to the risk prole of what we commonly think of as options.

When they go public, the companies continue to use megagrants out of habit and without much consideration of the alternatives.
But now they issue at-the-money options. As weve seen, the risk prole of at-the-money options on highly volatile stocks is
extremely high. What had been an eective way to reward key people suddenly has the potential to demotivate them or even spur
them to quit.

Some high-tech executives claim that they have no choicethey need to oer megagrants to attract good people. Yet in most cases,
a xed number grant (of comparable value) would provide an equal enticement with far less risk. With a xed number grant, after
all, you still guarantee the recipient a large number of options; you simply set the exercise prices for portions of the grant at dierent
intervals. By staggering the exercise prices in this way, the value of the package becomes more resilient to drops in the stock price.

Many of the Silicon Valley executives (and potential executives) that I have talked to worry a lot about joining post-IPO companies at
the wrong time, when the companies stock prices are temporarily overvalued. Switching to multiyear plans or staggering the
exercise prices of megagrants are good ways to reduce the potential for a value implosion.

Sleepy Companies, Sleepy Plans

Small, highly volatile Silicon Valley companies are not the only ones that are led astray by old habits. Large, stable, well-established
companies also routinely choose the wrong type of plan. But they tend to default to multiyear plans, particularly xed value plans,
even though they would often be better served by megagrants.

Think about your average big, bureaucratic company. The greatest threat to its well-being is not the loss of a few top executives
(indeed, that might be the best thing that could happen to it). The greatest threat is complacency. To thrive, it needs to constantly
shake up its organization and get its managers to think creatively about new opportunities to generate value. The high-octane
incentives of megagrants are ideally suited to such situations, yet those companies hardly ever consider them. Why not? Because
the companies are dependent on consultants compensation surveys, which invariably lead them to adopt the low-octane but highly
predictable xed value plans. (See the exhibit Which Plan?)
Which Plan?

The bad choices made by both incumbents and upstarts reveal how dangerous it is for executives and board members to ignore the
details of the type of option plan they use. While options in general have done a great deal to get executives to think and act like
owners, not all option plans are created equal. Only by building a clear understanding of how options workhow they provide
dierent incentives under dierent circumstances, how their form aects their function, how various factors inuence their value
will a company be able to ensure that its option program is actually accomplishing its goals. If distributed in the wrong way, options
are no better than traditional forms of executive pay. In some situations, they may be considerably worse.
1. Companies would also be well advised to abandon the practice of cli-vesting the options of executives who are voluntarily
departing. In cli vesting, the vesting periods of all option holdings are collapsed to the present, enabling the executive to exercise
all his options the moment he leaves the company. In other words, as soon as an executives departure date is set, much of his
incentive to think long-term disappears.

2. See Stephen F. OByrne, Total Compensation Strategy, Journal of Applied Corporate Finance (Summer 1995).

A version of this article appeared in the MarchApril 2000 issue of Harvard Business Review.

Brian J. Hall is the Albert H. Gordon Professor of Business Administration and

This article is about ACCOUNTING

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